Interview with Bud Labitan, author of "The Four Filters Invention of Warren Buffett and Charlie Munger"

September 28, 2008

Interview with Bud Labitan, author of "The Four Filters Invention of Warren Buffett and Charlie Munger"

MS: How old are you?

BL: I am 48 years old.

MS: When, and how did you, become a Berkshire Hathaway shareholder?

BL: I purchased shares in Wesco Financial first, then BRK.B's in 2000.

MS: What got you interested in Value Investing?

BL: In the 1990's, I was struggling in running a solo family medical practice in a competitive environment. I knew that I needed to learn more about business. Around 1995, Roger Lowenstein wrote a biography about Warren Buffett. This got me interested in effective business thought and effective rational investing.

BL: Each trip has been a happy and enlightening adventure. I have never seen so many happy people in one place at one time. I have been there 4 times. Janie and I went for the first time in 2001 when it was held at the old AKSARBEN (Nebraska spelled backwards) and there were about 17,000 people attending. I took my brother Clark there in 2005, and other friends in 2007 and 2008. Now, in 2008, there were close to 30,000. We meet up with friends and try new restaurants in Omaha. It is a beautiful small city with nice people.

MS: Did you learn anything interesting during the trip(s)?

BL: I always learn a lot from the older generation; successes as well as mistakes. One guy was an avid follower of insider trades. Another fellow is an expert on energy demand and supply flows. There are many students of Graham, Buffett, and Munger philosopy at these meetings. So, active listening yields bits of information to add to my latticework of business understanding.

MS: What do you think of Warren Buffett's, more silent partner, Charlie Munger?

BL: Like many, I have a great respect and admiration for Charlie Munger. He is a genius that has both complemented and grown from his partnership with Warren Buffett. Many people do not realize that Munger would have 30-40 billion if he had not been so generous to family and philantrophy. So, the genral public does not know much about his intellectual contributions to BRK's investing success. Warren Buffett put it this way: "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner." Keen readers of my book will notice how Munger's thinking help to shape the Four Filters process. Like pilots who use checklist prior to flying, the Four Filters help us frame a rational investment decision. Charlie Munger believes in using checklist routines to help us avoid a lot of errors. These errors occur because our human brains are wired to find shortcuts, or what Munger calls "shortcut types of approximations." Charlie Munger said: "The main antidotes to miscues from Availability-Misweighing Tendency often involve procedures, including the use of checklists, which are almost always helpful."

MS: Tell me about your book's design, and why did you structure it in the way you did?

BL: In 1949, Warren Buffett said that his life was transformed by reading Ben Graham's "The Intelligent Investor." So, "Four Filters Invention" is really the 2008 version of sensible intelligent investing updated by the amazing innovation of Buffett and Munger. I encourage keen minds to discover the hidden gems within the text. Having listened to many hours of audio lectures and interviews, I have been consistently interested in how Warren Buffett and Charlie Munger "frame" an investment decision, and how they find a winning investment prospect. This book is a story about the rational four filter process that help Buffett and Munger make better investing decisions. In the words of Charlie Munger, "You have to understand the odds and have the discipline to bet only when the odds are in your favor."

BL: Here is a bit about my book design process. My first intent was to write a book that my 16 year old daughter could read and appreciate on basic and motivational levels, depending on the level of her emotional maturity at the times that she reads it.(16, 20, 25, 30) I also wanted to tell this amazing story of how two brilliant friends innovated a major advance in Behavioral Finance, made a lot of money, and Behavioral Finance hardly noticed the intellectual achievement. (because it sounds so much like common sense.)

BL: Their brilliance was to take the "state-of-the-art" ideas after Ben Graham, blend it with ideas from Carret, Fisher, and Munger, and move the sequence around, compress it into 4 steps, and place the three most important words of Margin of Safety (IV estimation calculation) in the 4th and final step. Here is the audio clip to prove that sequence matters:

http://www.frips.com/4filters.mp3

BL: When I wrote this book, I tried to adhere very closely to Buffett and Munger's writings and speeches. There are however, transition sentences, that are designed to motivate like the book by Jim Collins' called "Good To Great." The key to appreciating my book is to read it a second time outloud. There are areas where subtle motivators have been planted to keep the "tone" upbeat and motivational. Look for areas where I write "we can" and "consider" and "may" and "optimize." ... subtle motivators. After all, this book is about learning the optimal way to "frame" our tough decisions and consider the major stakeholders.

BL: Here are the "layers" I imagined in designing this book:

1. 4-filters "decision framing" innovation of Buffett and Munger

2. Contributions to the notion of checklists from Munger, Fisher, Carret

3. A bit on how the 4-filters expand out the latticework of understanding

4. "subtle motivators" in transition sentences

5. My assertion that Buffett and Munger advanced Behavioral Finance by getting all the major stakeholders into this 4 step process. (if they were academics; worthy of Nobel in Economics and Behavioral Finance)

6. a motivator for my Daughter to "think rationally" when she grows up.

MS: Can you tell us a little about The Four Filters?

BL: "The Four Filters Invention of Warren Buffett and Charlie Munger" is about the amazing intellectual partnership of two brilliant men; and their contribution to "decision framing." I came to the realization that the 4 filters encapsulate all the important stakeholders. Warren Buffett has talked about the Four Filters in several ways. This behavioral sequence is always similar: "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. Buffett has also phrased the Four Filter process in this way: "When buying companies or common stocks, we look for understandable first-class businesses, with enduring competitive advantages, accompanied by first-class managements, available at a bargain price." These ideas sound so simple. Many people hear them at the Berkshire Hathaway annual meeting in Omaha each year. Yet, I suspect that few people have stopped to think about the importance and effectiveness of each individual filter. My book discusses each of the four clusters and tehn presents a brief case study on their Kraft stock purchase.

MS: Your decision to pick Kraft (KFT) in the book was very wise. How did you go about choosing that stock over all others?

BL: I cannot claim wisdom here. Kraft was added to Dow Industrials after the plunge in AIG. But, I could not have predicted this.

Kraft, KFT, is the valuation case example discussed after chapter 4 of my book. Back in March, I chose it over doing a valuation on "Bank of America" because I thought that folks could relate better to a food company they know from tasty brands. Kraft cheeses, dinners and dressings; Oscar Mayer meats; Philadelphia cream cheese; Maxwell House coffee; Nabisco cookies and crackers and its Oreo brand; Jacobs coffees, Milka chocolates and LU biscuits. Kraft has more than 50 additional brands with revenues of at least $100 million. I like the A1 steak sauce. Respected brands can translate into some measure of pricing power.

By the way, before I forget, this book can also be used as a supplemental text for classes: Valuation, Decision Sciences, Investments, and "Mixed Qualitative and Quantitative Modeling." I think it helps to tech young people how to frame decisions using the relevant players.

MS: Any thoughts about the financial crisis now?

BL: Buffett and Munger both warned everyone in 2002 about the dangers of derivatives as financial Weapons of Mass Destruction. Now, we will all pay in the form of higher taxes or deflated purchasing power.

MS: What amount of research is required to obtain a "Circle of Competence"?

BL: This is the toughest question you have asked. I do not know the answer. But, allow me to speculate intelligently and use Ben Graham's tenth lecture as a reference. In that tenth lecture, Graham is saying goodbye to his class. He knows that many of them will go out to Wall Street and speculate. In essence, he tells them that if they do, try to do so with some measure of intelligent thinking using their learned knowledge and sense of probabilities. In summary, use a margin-of-safety and try to limit potential losses. Now, fast forward in time to 1977 and the Buffett and Munger era. My assertion is that Buffett and Munger's Four Filter process advances Behavioral Finance because it captures all the major stakeholders in these four thinking steps. Since our personal "Circles of Competence" or "Latticeworks of Understanding" will be imperfect. The goal should be to build upon them not with trivia, but with valuable tidbits and insights. Add a little bit more to each cluster: Products, Customers, Managers, Margin of Safety.

MS: Can you give us some examples of a Durable Competitive Business?

BL: I always question durability. I think more in terms of "probability to endure 10 years." Greenwald warns us to not lose sight of the big question: "Are there barriers to entry that allow us to do things that other firms cannot?" After establishing the importance of barriers to entry, Greenwald and Kahn argued that there are really only three sustainable competitive advantages; 1. Supply. A company has this edge when it controls an important resource: A company may have a proprietary technology that is protected by a patent. 2. Demand. A company can control a market because customers are loyal to it, either out of habit - to a brand name, for example - or because the cost of switching to a different product is too high. 3. Economies of scale. If your operating costs remain fixed while output increases, you can gain a significant edge because you can offer your product at lower cost without sacrificing profit margins. The durability part is almost like love and honor. There is sometimes an emotional component to the purchase decision called brand. I believe that the durability of your competitve advantage lies in honoring the clusters of Products, Customers, and Trustworthy Managers.

MS: What tools do you use to determine if management is "able and trustworthy"?

BL: My book mentions an approach borrowed from medical doctors that encourages readers to use both their subjective feelings and their objective facts. Take a closer look at chapter 3. One easy way to spot suboptimal or "bad" managers is to calculate what percentage of the operating profits they are being paid in total compensation. In the training of Family Physicians, they teach young doctors to have a "High Index of Suspicion" in formulating a differential diagnosis. As a shareholder, trust-but-verify that your managers are building "intrinsic value per share." The market price will eventually follow. For, as a shareholder, and part owner of a fine business, do you want a manager taking more money from your pocket and putting it into his or her pocket? We want to be associated with builders of "intrinsic value" rather than takers of "market value." In evaluating business acquisition candidates, Warren Buffett and Charlie Munger want their businesses run by managers they like, admire, and trust. The book also mentions eleven factors from Phil Fisher to look for.

MS: Can you explain Margin of Safety (MoS)? The short answer is "amount of bargain."

BL: Knowing an "estimated intrinsic value" gives you this margin of safety. So, buying something worth $1 for 50 cents gives you a 50 cent margin of safety. What is an appropriate level of MoS? Each investment manager comes to this decision based on both their subjective feelings and their objective facts.

MS: Any other books that you recommend?

BL: I am a big fan of Roger Lowenstein and Andy Kilpatrick. In addition to the writings of Warren Buffett and Charlie Munger, I have also enjoyed reading the fine books written by Benjamin Graham, Philip Fisher, Philip Carret, Janet Lowe, Warren Boroson, Robert Hagstrom, Robert Miles, Bruce Greenwald, Timothy Vick, Michelle Leder, Christopher Browne, and Charles Mizrahi.

MS: As you get older, do you think you'll become more conservative with investments? If so, which asset classes?

BL: I prefer to use the words "wiser with investments". Use the Four Filters process and bet bigger when the odds are heavily in your favor. So when are the odds weighted more heavily in our favor? Warren Buffett said it best: "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. The Four Filters give us a better idea of when to swing the bat.

MS: What is the main benefit of reading your book?

BL: This book is really about sensible decision framing. I hope my daughter and other readers will appreciate this work and learn how to better "frame" their other important decisions.

"The Four Filters Invention of Warren Buffett and Charlie Munger" by Bud Labitan is available at Amazon.com:

Thanks to readers who bought the filters book. I think you will find it to be an enduring QB, quality bargain purchase. The tumolt on Wall Street is very scary to many people. And fear slows down trust, credit, and transactions flow. Time will continue to prove that "sensible investing" is really all about finding and "properly valuing" Quality Bargains. A lot of the junk derivatives on Wall Street are now unwinding.

My post today is about QB. Quality Bargains. I found this material on a post at the MSN BRK board, and decided to share it with readers here for additional discussions.

Interestingly, 2008 has been a "very" active investing/purchasing year for Warren Buffett and Charlie Munger at Berkshire Hathaway. Starting in December of '07, large quality bargains have been appearing and 2008 has turned into a very active year for investing BRK's cash.

I'm not sure either GE or Goldman Sachs fits the model of a simple, understandable business. It's also not entirely clear that Goldman Sachs has a sustainable competitive advantage, given the seismic shifts in the investment banking business now occurring. Whether the managements of either company are "able and trustworthy" is somewhat questionable as well: would able and trustworthy managers put their companies in such a desperate position that they needed to raise capital on such onerous terms from Warren Buffett?

It seems that Buffett's investments in Goldman and GE are based on a 'fifth filter': which companies are too big to fail, or, in the case of Goldman, too well-connected politically to fail.

I see your point and angle of view here. Consider the more flexible and broader use of "Understandable" here as "understanding the situation." or "Latticework of Understanding." I touched briefly in the book about this when Buffett looked at the old Sanborn Map Company. He saw value where others did not. GS and GE probably have better "able and trustworthy" managers than most. And soon, I think the pendulum of fiduciary monitoring will swing towards greater regulatory oversight.

Your idea of a "fifth filter" is fascinating. I even toyed with the idea of playing with George Soros Theory of Reflexivity in searching for a fifth filter like a hidden particle of physics, and calling it the "catalyst filter."

In the end, I decided to stick to the 4 main ideas Buffett and Munger talk about.

How about "We The People." Both, GE and GS will have the backing of a broad range of interests across the political spectrum in this USA as well as most industrialized nations. So, one could argue that these are two global institutions worth preserving and reviving to greater strength.

DaveinHackensack, if you decide to do a book on a historical or catalytic fifth filter, that would be an interesting area to explore. And, I would urge you to look at Ben Graham's tenth lecture on "Intelligent Speculation" as well as George Soros "Theory of Reflexivity" for historical inflection events.

My take on Buffett and BRK's investments in GS and GE?

We could debate Sust,CompAdvantages in both companies, but Buffett's quote kind of sums it up: "We just read the newspapers and go by our own sense of probabilities."

The downside is protected by a 10% bond(loan) and the upside could be quite amazing.

Excerpt from yesterdays talk between Charlie Rose and Warren Buffett about the GS and GE deals.

Charlie Rose:

Let me talk with the news of today. You have announced an investment of $3 billion in General Electric, along the same terms as the the Goldman Sachs --

Warren Buffett:

Yeah, almost identical.

Charlie Rose:

Why GE?

Warren Buffett:

Well, I got a call this morning from a friend of mine at Goldman Sachs saying they might be interested in, in such an investment. I'm familiar with the company. I've known the management, the current management, Jack Welch before Jeff Immelt. I've known him for decades. And so I understand their businesses. We do lot of business with him, and GE has been -- I think it's the longest running stock in the Dow Jones industrial average. It will be 100 years now it will be around. I hope I'm around then, too. And it was an attractive investment. And we've had a lot of money around, over the last two years, and we're seeing things that are attractive now.

Charlie Rose:

Are you looking at other things?

Warren Buffett:

I look at everything, Charlie. That's my job. I really do. I mean every day, I think about everything, yeah.

Charlie Rose:

I know, but cash is said to be king now. Are you sitting on a lot of cash so that this is the time for Berkshire Hathaway and Warren Buffet to look carefully at a lot of opportunities.

Warren Buffett:

Yeah, we want to use cash. The reason we haven't used our cash two years ago, we just didn't find things that were that attractive. But when people talk about cash being king, it's not king if it just sits there and never does anything. There are times when cash buys more than other times, and this is one of the other times when it buys a fair amount more, and so we use it.

Charlie Rose:

There is a time to accumulate and a time to spend.

Warren Buffett:

Absolutely. You want to be greedy when others are fearful and You want to be fearful when others are greedy. It's that simple.

Charlie Rose:

What are they now?

Warren Buffett:

They're pretty fearful. In fact, in my adult lifetime, I don't think I've ever seen people as fearful economically as they are right now.

Charlie Rose:

And why is that, do you think?

Warren Buffett:

Well, it's because they -- they have seen the credit market seize up. They're worried about money market funds, although the latest proposition from government should take care of that. They've seen eight percent of the bank deposits in the United States get moved very skillfully, I might say, within the last couple of weeks from institutions that they thought were fine a few months ago to other institutions. They are not wrong to be worried.

Here is a new example of the "four filter clusters" I found in Warren Buffett's latest talk with Charlie Rose on 10/01/08. Think of the Four Filter Clusters when you read the excerpt further below, and I will show you how they line up with slightly different words.

1. Understandable => "things I can understand"

2. Sust.Comp.Advantage => "fundamentally good economics"

3. Able n Trustworthy Managers => "a management that I like and trust and admire"

4. Bargain Price => "it's got to be a price that makes sense"

Charlie Rose:

Is there an operative narrative to the kinds of investments you are making other than you look at and you buy on value, look at advantage, management, you look at a place that can absorbed the amount of money you want to invest, and you look at its prospects, and you look at price.

Warren Buffett:

Yeah. They have to be pretty good size for us now to have... to move the needle. But we look for fairly large situations.

We look for things I can understand. A lot of businesses I don't understand. So some guy may know how to make money in cocoa beans, but I don't so I just let him have that. But it's got to be something I understand. It's got to be a business with fundamentally good economics. It's got to be a management that I like and trust and admire. And it's got to be a price that makes sense. And lately the price --

Regarding the 'fifth filter': I forget who it was who said it (maybe Jim Rogers or Ken Heebner?) but some investor suggested that if you are bullish on the economic prospects of a particular country, invest in that country's largest bank. First, banks tend to be pro-cyclical, so they normally do well in strong economies; second, if the largest bank in a country runs into trouble, chances are, that country's government will step in to bail it out.

On a more general and conceptual note, "time" is sort of like that mysterious fifth filter. Time allows market values to approach intrinsic values. Time displays amazing market driven opportunity events. Time rewards those with a patient temperament. According to Buffett and Munger: "Time is the friend of the wonderful business and the enemy of the mediocre."

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